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Merchants, which have continued to oppose the Durbin interchange fee caps set by the Fed, won a huge victory in court on July 31. In NACS et al v. Board of Governors of the Federal Reserve System,U.S. District Judge Richard Leon in Washington, D.C., ruled that the Federal Reserve Board of Governors overreached in its interchange and network routing rulemaking.

The decision, which, if upheld, will have huge consequences for issuers, program managers and other payments stakeholders, calls for the Fed to revise its rule without taking into account any fixed costs associated with processing transactions, such as fraud losses or transaction monitoring, and asserts that network routing rules must require at least two unaffiliated networks for each authentication method—signature and PIN. Under the current rule, issuers can meet the routing requirements by having at least one signature and one unaffiliated PIN-debit network.

“I find that the text and structure of the Durbin Amendment, as reinforced by its legislative history, are clear with regard to what costs the board may consider in setting the interchange fee standard: Incremental ACS [authorization, clearance and settlement] costs of individual transactions incurred by issuers may be considered. That’s it!” the judge wrote in his decision.

Durbin Urges Fed to Lower Interchange Fee Caps in Line with EU Proposal Before the judge’s July 31 ruling in the merchants’ lawsuit against the Fed, Sen. Dick Durbin (D-Ill.) and Rep. Peter Welch (D-Vt.) already were calling upon the Federal Reserve to lower debit interchange fee standards in line with recently proposed regulations issued by the European Commission (EC). In a letter to Federal Reserve Board Chairman Ben Bernanke, the lawmakers urged the Fed to review the regulation caps proposed by the EC and include them into the board’s assessments of debit interchange fees charged in the U.S., particularly with respect to small-dollar debit transactions.The EC’s proposal recommends capping debit and prepaid card interchange fees at 0.2 percent and credit interchange at 0.3 percent of the transaction value. Interchange fees in the European economic region currently range from 0.1 percent to 2.5 percent, according to the EC. The regulations initially would cover cross-border transactions; then apply to all card transactions within about two years. The regulations also would prohibit rules requiring merchants to accept all cards within a particular network (a.k.a., the Honor All Cards rule), and prohibit rules preventing merchants from steering customers to lower-cost payment methods.

To pass into law, the plan requires the approval of the European Parliament and the European Union member states.

The Federal Reserve final rule caps debit card interchange fees at 21 cents per transaction plus 0.05 percent of the transaction amount to pay for fraud losses and a separate fraud-prevention adjustment of 1 cent to pay for “effective” fraud prevention policies and procedures. The 21-cent cap was half of the 44-cent average issuers were receiving for debit transactions in mid-2011. The court’s language suggested that a cap of 7 to 12 cents was more in keeping with Congress’ intent.

The court also ruled against the Federal Reserve’s rule regarding network exclusivity, concluding that the statute requires merchants to be provided with a choice between multiple, unaffiliated networks for each transaction, not just a choice over two or more unaffiliated networks. According to the court, “Congress intended for each transaction to be routed over at least two competing networks for each authorization method.” Again, citing statements from Sen. Dick Durbin (D-Ill.), the court agreed that the non-exclusivity and routing provisions were meant to “inhibit the continued consolidation of the dominant debit networks’ market power and to ensure competition and choice in the debit network market.” Thus, “any reading [of the statute] that denies merchants the ability to choose between multiple networks for each transaction cannot be squared with a statute that plainly requires at least two networks per transaction.” This means that each card that offers signature and PIN debit transactions must provide two signature network routing options and two PIN network routing options.

The judge denied the merchants’ request for a stay of the current rule, which remains in effect, but he noted that the Fed had months—not years—to finalize new rules.

What It Means

“First, I assume the Board of Governors will appeal the decision, so it may be a year before we know the final outcome,” says Terry Maher, partner at Baird Holm LLP. “If the ruling is upheld, I expect that the interchange fee cap will look more like what was proposed in the interim final rule—somewhere between 7 and 12 cents,” he tells Paybefore.

While any reduction in fee caps will hurt issuers’ bottom lines, Maher says the network routing issue could be even more problematic. Issuers may be more likely to opt for two signature networks on a card—something that is unheard of today—rather than two PIN networks, given the lack of PIN pads at certain merchants. “The industry will have an interesting challenge of figuring out how two signature networks coexist on the same card,” he says.

“Ultimately, if the decision is upheld, there will be a significant increase in costs to issuers and program managers that may find their way to the consumer.” Lower fee caps also could affect the appetite of large, nonexempt issuers (over $10 billion) for nonreloadable prepaid cards, such as gift cards or corporate promotions, which are not exempt from the caps. “It’s a dramatic decision, and if it is upheld, it’s going to have a real impact—more on debit cards but also on prepaid cards.”

Merchant Reaction

Merchants applauded the court’s decision. The National Retail Federation, which was one of the plaintiffs in the case, issued the following statement from Senior Vice President and General Counsel Mallory Duncan: “From the very beginning, retailers and restaurants knew the Federal Reserve Board of Governors had grossly misapplied the swipe fee law, also known as the Durbin Amendment. They failed to heed Congress’ call to set fee standards that were ‘reasonable’ and ‘proportional’ to the actual cost of a transaction. Instead, the board manufactured a standard that was two to three times higher than the Fed staff recommended. As a result, small ticket transactions, such as those imposed on convenience stores and restaurants, skyrocketed under the misapplied law.”

On average, merchant interchange costs per transaction have declined under the Fed’s interchange caps, according to a May report from Federal Reserve Bank of Kansas City. But cost saving depends on a merchant’s size and sector. Utility companies, hotels and e-commerce merchants saw higher saving from interchange caps, while merchants with a high proportion of small-ticket transactions, such as coffee shops and fast-food operators, saw an increase in interchange fees, according to the report. That’s because a $5 signature debit transaction that cost 12 cents before the cap took effect rose to about 22 cents for a large bank-issued debit card, which tends to hurt merchants with many smaller transactions, according to report author Fumiko Hayashi, senior economist, Federal Reserve Bank of Kansas City.

The implementation of the rules related to the Durbin Amendment has had far-reaching effects on every entity in the payments value chain. And whatever changes might be ahead are likely to be significant as well.If the Fed wins on appeal, then the merchants can appeal again to the Supreme Court and it would be up to the High Court to decide whether or not to hear the case.

Importantly, the ruling does not impact the exemption for certain GPR cards, and some believe if this ruling stands, it may encourage a move toward more prepaid cards, according to Judith Rinearson, partner at Bryan Cave LLP.

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